The South African bond market: A practitioner’s perspective of progress, problems and prospects Presentation to OECD seminar on “How to reduce debt costs in Southern Africa” , Johannesburg, 25/26 March 2004
Economic efficacy: Yield curve predicts IP (most cyclical, large component of GDP) by about a year. Current spread predicting sustained turnaround in IP cycle later this year.
Policy efficacy: Bond investors/SARB constantly keeping an eye on each other, with long rates usually leading short rates by six months, except during sudden “crisis” events.
A very brief history of SA’s macroeconomics
Macro theory would posit transmission mechanism of falling savings => falling investment => rising real rates => lower growth. SA delivered a textbook response after 1980.
Open economy macro theory would posit need for rising real rates on abolition of dual currency regime in 1995, allowing current account deficit to be adequately funded
SA yield dynamics and structural adjustment
Falling cyclicality has been primarily due to halving or more of sustainable inflation since onset of 1) real rate regime (from 1988) and 2) exchange control relaxation (from 1995)
Lagged response of yields to inflation evident in rising real yields, reflects bond investors’ vigilantism towards inflation risk and thus sustainable achievement of 3-6% CPIX target
SA bonds outperform equities and inflation
With lower cyclical economic volatility, primarily due to sustained macro-level reforms, bonds have structurally outperformed equities since 1986, but markedly so since 1994
As a result, bonds have been a superior inflation hedge. While this is a dire verdict on risky asset returns in the last decade, it reflects the high costs of structural adjustment.
Legacy drag on institutional asset allocation
SA fund managers have been mandated to relatively outperform, thus institutionalising a risk bias towards equities, which are also thought to have better inflation-hedge qualities
Where we have seen bond investors’ reticence to fully discount a sustained fall in inflation risk, it is no real surprise that this pro-equity asset allocation legacy continues to persist
Impact of fiscal policy on SA’s bond market
Steady not stellar growth in SA bond market
Some diversification in concentrated market
Fiscal conservatism drives sovereign rating
Shifting issuance bias in SA bond market
Cash-flows funding private capital intensity
Steady not stellar growth in SA bond market
Bond capital raising will be a function of the economy’s savings constraint; as we have seen, SA’s reforms have helped to dampen GDP risk but not yet revive trend growth
In US$ (numeraire) terms, while SA’s bond market is barely changed from a generation ago, it remains comparable, in (US$) GDP terms, to Russia, China and South Korea
Less domestic sovereign dominance with growth in foreign and corporate issues
Concentrated liquidity in benchmark issues; SAGB, parastatal and corporate
Fiscal conservatism drives sovereign rating
Given a budget deficit overhand from political settlement, reducing public sector debt was the anchor input of a wider strategy to reduce inflation and liberalise the economy
The financial payback for a steady lowering in debt service costs has been a steady improvement in SA’s credit rating, from “junk” to “investment” grade in the last decade
Shifting issuance bias in SA bond market
SA’s improving credit rating has continued to pave the way for more global issuance, subject to Treasury’s self-imposed current 80% (local)/20% (foreign) funding “rule”
Improving deficit and debt profiles, coupled with a steadily rising share of foreign issuance has substantially removed a crowding-out effect to abet corporate issuance
Cash-flows funding private capital intensity
With aggregate savings, a lower budget deficit has on a relative basis been taken up by lower household saving, reflecting low income tax cuts and rising retail credit intensity
For SA’s financial intermediaries, as companies have met rising fixed investment needs from flush cash-flows, this has meant growth in bank credit relative to bond issuance
Maturity profile and yield spread dynamics
Towards a smoother SA issuance profile
Foreign issues: smallness means lumpiness
Country premia more relative than absolute
Credit vs. liquidity risks in corporate spreads
Spreads consistency reflects efficient market
A note on inflation-linked bonds (ILBs)...
Towards a smoother SA issuance profile
Foreign issues: smallness means lumpiness
Country premia more relative than absolute
While SA’s sovereign risk premium has improved since 1996, so too have many other country ratings, especially the EU convergence trades, which have leap-frogged SA
Significantly, in the tightening of EM spreads since 4Q02 to risk levels last seen in 1997 (i.e. pre-Asian crisis), SA’s credit returns have mostly mirrored those of EM’s generally
Credit vs. liquidity risks in corporate spreads
Sub-sovereign (parastatal) and corporate debt reflect appropriate spreads of underlying credit or earnings risk: tighter/stable for annuity cash-flow operations such as utilities
Tighter parastatal spreads also reflects implicit govt. backing of default risk. As elsewhere, credit quality determines relative spread elasticity to benchmark SAGB yield dynamics.
Spreads consistency reflects efficient market
For a yield curve with reliable leading indicator properties, it follows that changes in relative spreads reflect appropriate risk-adjusted “bets” of bond investors
Where liquidity has been dominant in the 5-year and 10-year areas of the curve, most directional “bets” are in terms of 2-year/5-year or 2-year/10-year spread trades
A note on inflation-linked bonds (ILB’s)...
In tandem with the introduction of the inflation target in 2000, National Treasury has issued four ILBs across the maturity spectrum, currently accounting for 6% of issuance
While still relatively illiquid, it is possible to derive from their real yield differentials distinct discounted future inflation expectations for comparison to consensus forecasts
FX risk; benchmark and ownership issues
SA bonds are better insulated from FX risk
SA in EM: Small in bonds but big in equities
FPI flows reflect benchmark characteristics
Foreigners are mature owners of SA assets
Structural bond ownership patterns persist
SA bonds are better insulated from FX risk
The recent profile of FX risk is ambiguous: on one measure (relative yield derived), SA currency risk has declined but on another (FX volatility derived) it has increased
Since the former is more stable, one could conclude that local yields have become less sensitive to “pure” FX risk, a conclusion consistent with an improving sovereign rating
SA in EM: Small in bonds but big in equities
Dedicated capital flows are an important source of capital for EM’s. For such investment, bond investors are benchmarked to the EMBI+ and equity investors by MSCI’s EMF
Financial sanctions and an alternative foreign debt restructuring left SA with a low EMBI+ weight but established, large companies ensured SA a high MSCI EMF weight
FPI flows reflect benchmark characteristics
Following the abolition of the Finrand and inclusion in benchmark indices, SA could capitalise on FPI as the main source of financing a renewed current account deficit
Given SA’s apposite benchmark status in bonds and equities has seen latter dominate FPI inflows, but “off-index”, opportunistic bond inflows can be temporarily large
Foreigners are mature owners of SA assets
Foreign asset and liability position (for latest 2001 data) confirms foreigners’ preference for domestic equity over bonds, with a notable public vs. private source of funding split
Significantly, in US$ terms, it would appear that without further structural changes to SA’s asset markets, there is little scope for foreigners to raise their ownership stakes
Structural bond ownership patterns persist
Even as the PIC has sought to diversify its historic asset allocation bias from bonds to equities, this has been achieved via cash-flows, especially during debt-buyback years
By being on the other (asset allocation) side of the market, the PIC posted impressive relative returns from its high bond exposure, helping GEPF to close its net funding gap
Some conclusions and suggestions
Treasury deserves plaudits for macro restructuring that has helped to stabilise economy and consolidate the bond market
It remains critical that inflation targeting success completes this contribution to a sustained re-rating in SA’s real debt costs
Lower real yields should be matched by further sovereign credit re-rating, and thus an ability to unwind bond market overhangs
Critical to this process will be: boosting bonds’ benchmark asset allocation; reducing PIC dominance and more off-shore issuance
This would facilitate more foreign participation as well as boost capacity for bond financing of new net fixed capital formation
The bond market is merely one financial intermediary for savings and investment, which remain a function of economic growth
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